This tutorial explains the mechanics and effects of quantitative easing (QE) conducted by central banks, particularly the Federal Reserve from 2008 to 2014. It outlines how QE operates through open market purchases, which increase bank reserves and the monetary base but may have varying effects on the economy, including challenges in linking monetary policy to economic recovery. Despite its limitations, the document suggests that QE likely mitigated recession impacts and facilitated some degree of economic recovery.

1. Economics for your Classroom from
Ed Dolan’s Econ Blog
Quantitative Easing and the
Fed: 2008-2014
A Tutorial
Revised November 2014
Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free
to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like
the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.

2. Understanding Quantitative Easing
 Central banks—the Federal
Reserve, the European Central
Bank, the People’s Bank of China,
and others—are among the most
powerful institutions in the world
 One of their potentially most
powerful but least understood
instruments is Quantitative Easing
or QE, a type of policy that the Fed
pursued for six years, from late 2008
to late 2014
 This tutorial explains the mechanics
of QE and its effects on the US
economy
Federal Reserve Building,
Washington, DC
Photo by Agnosticpreacherskid,
http://upload.wikimedia.org/wikipedia/commons/8/8d/Marriner_S._Eccle
s_Federal_Reserve_Board_Building.jpg
Revised version November 2014 Ed Dolan’s Econ Blog

3. Quantitative Easing
Part 1:
The Mechanics

4. The Central Bank Balance Sheet: Assets
 Fig 1 gives a stylized balance sheet
of a typical central bank
 Net domestic assets consist of all
assets denominated in the country’s
own currency, e.g., bonds issued by
its government, adjusted by
subtracting certain liabilities and
capital
 Net foreign assets consist of all
assets denominated in foreign
currencies, e.g., bonds issued by
foreign governments, adjusted by
subtracting foreign liabilities, if any
Revised version November 2014 Ed Dolan’s Econ Blog

5. The Central Bank Balance Sheet: Liabilities
 The sum of the items on the
liabilities side of the balance sheet is
called the monetary base, which
consists of two parts
Reserve deposits that private
commercial banks hold with the
central bank
Currency (paper money)
Revised version November 2014 Ed Dolan’s Econ Blog

6. The Central Bank and Commercial Banks
 The central bank balance sheet is
linked to those of commercial banks
through reserves of liquid assets held
by commercial banks:
Reserves of currency used to fill ATM
machines and serve other needs
Reserve deposits in accounts that
commercial banks maintain with the
central bank
 Loans to consumers and firms are
banks’ main income-earning assets
 Bank deposits held by consumers and
business firms are banks largest
category of liabilities
Revised version November 2014 Ed Dolan’s Econ Blog

7. The Complete Financial System
 We complete our stylized picture of the
financial system by adding the balance
sheet of the “nonfinancial public,”
consisting of all private firms except
commercial banks and all households
 The public balance sheet is linked to the
central bank via currency—an asset of
the public and a liability of the central
bank
 Bank deposits are an asset of the public
and a liability of commercial banks
 Loans—an asset of commercial banks
and a liability of the public—are the last
important link among the balance sheets
Revised version November 2014 Ed Dolan’s Econ Blog

8. The Money Stock and the Equation of Exchange
 The nation’s money stock or money
supply consists of the total value of
currency and bank deposits held by the
public. (Currency held by banks is not
included). The most common measure of
the money stock is known as M2
 In practice, bank deposits form 80 to 90
percent of the money stock in the
monetary systems of developed
countries, and currency plays a minor
role
Revised version November 2014 Ed Dolan’s Econ Blog

9. Central Bank Open Market Operations
 Open market operations are one of the
most important tools that central banks
use to control the money stock
 These are purchases or sales of assets
(usually government securities) from or to
the public via secondary markets that are
open to all buyers and sellers—hence the
name “open market” operations.
Note: This and subsequent slides use “T-accounts,”
which are simplified balance
sheets that only show items that change
as a result of whatever operation we are
discussing
Revised version November 2014 Ed Dolan’s Econ Blog

10. Open Market Operations Step-by-Step
 Step1: The central bank adds to its
holdings of domestic securities by buying
them from a bank
 Step 2: In return, the central bank credits
an equal amount to the bank’s reserve
account
 Step 3: The result is an increase in bank
reserves and in the monetary base
Revised version November 2014 Ed Dolan’s Econ Blog

11. Open Market Operations: Alternative Version
 Step1a: Alternatively, the central bank
could buy the securities from dealers who
are not banks or from other members of
the public
 Step 2a: The central bank pays for the
securities using a payment order that is
executed through the banking system.
Sellers of the securities receive payment
as deposits added to their bank accounts
 Step 3a: To complete the payment
process, the central bank adds an equal
amount to the reserve deposit of the
commercial bank or banks where the
sellers keep their accounts
Revised version November 2014 Ed Dolan’s Econ Blog

12. Further effects of open market operations
 The immediate effects of an open market
operation are increase in bank reserves
and the monetary base
 Subsequently, banks may make new
loans to members of the nonfinancial
public
 If they do so, the proceeds of the loans
are paid out to the borrowers in the form
of added bank deposits. The result is a
further expansion of the money supply
with no further change in reserves or the
monetary base
Revised version November 2014 Ed Dolan’s Econ Blog

13. The Costs of QE: Recycling Interest Payments
 What, if anything, is the cost of QE to the
Fed? To the government as a whole?
 When the Fed buys securities, interest it
collects is a source of income for the
Fed, but the Fed is not allowed to profit
from it.
 After deducting its operating costs, it
turns any surplus back to the Treasury.
 In the simplest case, where the securities
purchased are government bonds, QE is
purely a bookkeeping operation with no
immediate cost to the Fed or to the
government as a whole
The Fed
The
Treasury
Treasury photo by David Monack, http://commons.wikimedia.org/wiki/File:GallatinTreas.jpg
Revised version November 2014 Ed Dolan’s Econ Blog

14. Possible Indirect Costs
 Qualification No 1: Since 2008, the Fed
has begun paying interest on banks’
reserve deposits, so not all the interest
is recycled, however, the interest rate is
low—just 0.25 percent.
 Qualification No. 2: The Fed may not be
able to hold its big QE purchases of
bonds forever. Sooner or later, the
economy will begin to recover. The
Fed’s exit strategy from QE may
require selling off many of the extra
securities. Under some conditions, it
might have to sell them at a loss
Photo: © BrokenSphere / Wikimedia Commons
Revised version November 2014 Ed Dolan’s Econ Blog

15. Quantitative Easing
Part 2:
The Effects

16. Effects of Open Market Purchase: Traditional Textbook Version
According to a traditional textbook model,
open market operations affect the economy
through two key ratios:
The ratio of the M2 money supply to the
monetary base is known as the money
multiplier
The ratio of nominal GDP to the money
supply is known as the velocity of circulation
of money, or, for short, simply velocity
If the money multiplier and velocity were
fixed constants, then the Fed could control
the economy as easily as a child can control
a model train
Revised version November 2014 Ed Dolan’s Econ Blog

17. Before QE
 The first massive purchases of
assets by the Fed, now known as
QE1, began in mid-2008
 Before that time, the money
multiplier and velocity ratios in
reality been approximately constant,
as we can see from the fact that the
monetary base, the money stock,
and nominal GDP tracked closely
together.
 Note: In this and the following
figures, the base, the money stock,
and GDP are all charted with their
values for Jan. 2008 = 100
Revised version November 2014 Ed Dolan’s Econ Blog

18. Effects of QE1
 As soon as the Fed began the first
phase of QE, however, the
economy stopped behaving
according to the textbook model
 The monetary base grew rapidly,
but the money stock grew only
slightly. The growing gap between
the curves indicates a rapidly falling
money multiplier
 The money stock increased but
nominal GDP at first continued to
fall. The gap between the curves
indicates a decrease in velocity
Revised version November 2014 Ed Dolan’s Econ Blog

19. From QE1 to QE2
 Because QE1 failed to get the
economy back on track, the Fed
decided to try again. From late 2010
to mid-2011, it carried out an
additional large scale purchase of
assets that became known as QE2
 Nominal GDP did begin slowly to
increase, but the effects of QE2
were weak and the curves
continued to diverge
Revised version November 2014 Ed Dolan’s Econ Blog

20. Finally, QE3
 In September 2012 the Fed decided
to begin a third round of easing, QE3
 Unlike QE1 and QE2, QE3 had no
specified end date, but was intended
to continue until the economy
improved
 As under QE1 and QE2, the curves
continued to diverge. There was no
mechanical linkage between
monetary policy and the economy as
a whole, but nominal GDP did
continue to grow and the economy
began slowly to improve
Revised version November 2014 Ed Dolan’s Econ Blog

21. Progress toward the Fed’s Targets
 The Fed sets official targets of
2 percent for inflation and
5.25-5.75 percent for
unemployment
 By late 2014, unemployment
had fallen to 5.9 percent. The
Fed decided that there had
been enough progress toward
the targets to bring QE3
officially to a close
 Did QE work? Can the Fed
take credit for the recovery, or
would the economy have
recovered anyway?
Revised version November 2014 Ed Dolan’s Econ Blog

22. How QE may have worked
 Supporters of QE say we should not expect it
to work through rigid ratios like the money
multiplier and velocity
 One theory says that it works by changing
the relative amounts of long- and short-term
securities, thereby lowering long-term rates,
supporting stock prices, and encouraging
investment
 Another theory says the most important
effect is forward guidance, that is, changing
people’s expectations about what the Fed will
do in the future
Jackson Hole, Wyoming
Source: Enricokamasa via
http://commons.wikimedia.org/wiki/File:Corbet
%27s_Couloir_jackson_hole.jpg
For a detailed discussion of how QE
works, see this paper by Michael
Woodford presented at the Fed’s 2012
conference in Jackson Hole, WY
Revised version November 2014 Ed Dolan’s Econ Blog

23. Monetary vs. Fiscal Policy
 Supporters of QE place part of the
blame for a slow recovery on fiscal
policy, which is beyond the Fed’s
control
 Despite some stimulus in 2008 and
2009, fiscal policy soon became tighter
as Congress cut spending to reduce the
federal deficit (see chart on next slide)
 In the words of former Fed chairman
Ben Bernanke, “Monetary policy cannot
achieve by itself what a broader and
more balanced set of economic policies
might achieve.” (Speech of Aug 31, 2012)
Revised version November 2014 Ed Dolan’s Econ Blog
vs.

24. US Fiscal Policy, 2006-2014
 The best single measure of the
stance of fiscal policy is the
primary structural balance
(PSB), which is the surplus or
deficit, excluding interest
payments, that would prevail if the
economy were at full employment
 Fiscal policy moves adds stimulus
if the PSB decreases (down on the
chart) from year to year and
restraint if it increases (up)
 After 2009, fiscal restraint offset
much of the monetary stimulus
from quantitative easing
(Follow this link for a more detailed discussion)
Revised version November 2014 Ed Dolan’s Econ Blog

25. The Bottom Line
 The US experience with quantitative
easing shows that during a deep
recession, the central bank’s control
over the economy is weak. Trying to
stimulate the economy with monetary
policy alone is like “pushing a string.”
 Tight fiscal policy further limited the
effectiveness of quantitative easing.
 Nonetheless, it is likely that QE did
have a positive effect. Very likely the
recession would have been even
deeper and the recovery even slower
without it.
Revised version November 2014 Ed Dolan’s Econ Blog

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